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What Does Retirement Really Cost?

Most answers to questions about the cost of retirement are dangerously misleading and mask a critical market signal.

If there is one question that has captured the wallets and imaginations of baby-boomers contemplating retirement, it must be: Do I have enough … or will I live longer than my money?

Although I have spent a large part of my professional career pondering a myriad of financial matters, I must say that this particular vexing question — with all the complications of health care, income taxes and financial markets — might be one of those riddles wrapped in enigmas, to which it is impossible to provide a fully satisfying answer.

Unfortunately, a growing number of the retirement planning “tools and philosophies’’ that are widely used to answer these questions often give misleading results. More problematically, they then generate a false sense of security that you indeed do have enough, when in fact you don’t.

Now normally such problems would be beyond the mandate of this particular column. But one of the by-products of this faulty logic is that lifetime income products and specifically life annuities often get the short end of the stick when viewed through these tainted lenses. This, I believe, must be corrected and is the impetus for this month’s column.

Let us start with some basic retirement arithmetic. Imagine you are exactly 65 years old and would like to retire today. Besides the entitled income from government and corporate pensions, assume that you need an additional cash-flow of $1,000 per month ($12K per year) for the rest of your life. I will assume that you are not fooled by, or suffer from, what economists call money illusion and that these monthly desires are expressed in real inflation-adjusted terms (i.e. today’s dollars.)

So, how much of a lump-sum nest egg do you need today to generate this specified stream of income for the rest of your life?

Fortunately, this much more limited question is easier to address. The route to an answer begins with a present value analysis that assumes an investment return and assumes an investment horizon. Once you make these two assumptions, any business calculator can provide you with an answer. I have taken the liberty of displaying some values in the table on the next page, under a variety of life horizons and investment returns.

In particular, you will see values assuming investment returns of 0%, 1.5%, 4.0% and 6.5%, and income plans that last to age 84, 90 and 97. I have selected these odd-looking numbers deliberately, for reasons that should soon be clear.

I have also — in the same table — displayed the actual cost of a $1,000 per month life annuity, purchased at the age of 65, which is approximately $230,000 in today’s financial environment. This particular number is harder to obtain — a business calculator isn’t enough — and you have to contact your favorite insurance company for that. I’ll say more about the implication of this number in a moment.

Here is how to read and interpret the table. If you are retiring at the age of 65 and would like a $1,000 monthly income stream until life expectancy, which is age 84.2 — after which, I presume, you plan to shoot yourself — and this money is invested at a real rate of 1.5%, then you need a nest egg of a little over $200,000 at retirement. So says the math.

If you don’t trust these present value formulas then go ahead and build a spreadsheet to convince yourself that $200,000 invested at 1.5% / 12 = 0.125% per month (plus inflation) that experiences monthly withdrawals of $1,000 (plus inflation) will exhaust itself in exactly 19.2 years, which is the 50% mark on the longevity tables.

Now I deliberately selected 1.5% as the investment return in the above paragraph, since it is the best rate you can actually guarantee in today’s environment on an after-inflation basis. Note that in late July 2011, long-term inflation-linked (government) bonds are yielding 1.5%. We all might believe this is artificially low, but it is the best you can get if you want something that is guaranteed. The mighty bond market speaks.

Of course, if you worry about events that have probabilities smaller than 50% — like living beyond life expectancy — and you plan your retirement to the 75th percentile, which is age 90, then you need a retirement nest egg of approximately $251,000. This will generate the $1,000 monthly income for the extra six years. Stated differently, the present value of $1,000 per month until the age of 90 is $251,000 when discounted at 1.5%. And, if you worry about events with probabilities smaller than 25% and you plan to the 95th percentile of the mortality table, which is age 97, then you need a nest egg of $306,000 to generate the $1,000 of monthly income. Big numbers. Low rates.

This is a basic application of the time value of money, given today’s interest rates. Needless to say, most people look at the $305,000 price tag for a meager $1,000 of income and balk, or they get very depressed. Scale this up by a factor of 10, for those who want a monthly income of $10,000, and retirement will cost a cool $3 million if you want the money to last to the age of 97 — which is the 95th percentile of your lifespan.

So, time to take-up smoking, boozing and ditch the exercise bike?

Enter the retirement planning software used by confused — or unscrupulous — financial advisors and they seem to offer a better and more soothing answer. If you invest more aggressively then you don’t have to use the small, pathetic and depressing 1.5% real return column in the above table. If you purchase more equity-based mutual funds, or invest more heavily in stocks, then you are entitled to use the much higher 6.5% column — “Because in the long run, stocks have averaged 6.5% after inflation, even if you include the fees I will be charging.”

So, if you are willing to take a bit more equity market risk, all you need is $131,600 at retirement if you plan to life expectancy. And, even if your retirement horizon is age 90, then all you need is $148,600 at retirement, per $1,000 of monthly income. As for age 97, don’t worry about it (they say). Most people don’t reach that age.

Either way, as you can see, these numbers — how much you need at retirement — are certainly much less than the ones under the 1.5% column. Fix your asset allocation. Repair your portfolio. Assume your problems away. So says the software.

And, if you only have $100,000 in your retirement account and you absolutely must have $1,000 per month until age 85, here is another way to make the numbers dance.

If you surrender to the 1.5% return (by investing very safely), then your so-called “coverage ratio” will be $100,000/$200,000 = 50%, which is the relationship between what you have and what you need. This means that you can only cover 50% of your desired income. That’s your current (very safe) portfolio.

On the other hand, if you invest very aggressively — which then entitles you to use a 6.5% return — your coverage ratio can increase to $100,000/$131,000 = 76%. Sounds better, no? Which one would you like?

So, here is the first of my two points in black and white.

Assuming a more aggressive portfolio, in the hopes that you can move to the upper right-hand corner of the table — and hence require a smaller nest egg for retirement — is a mirage. You can’t tweak expected return (a.k.a. asset allocations) assumptions until you get the numbers that you like.

Very low real interest rates, such as the 1.5% currently available, translate into a high cost of retirement, and vice versa. Betting that these rates will eventually go back to normal, or that equity markets will make your retirement cheaper, is just that, betting.

Don’t get me wrong. There is nothing wrong with investing aggressively and holding stocks — I have said many times that my portfolio is pretty much 100% equity — but I am willing to take the chance that my retirement income might be reduced if things don’t work out. And I absolutely do not “price” my retirement income plans at the long-term expected return from stocks.

In fact, this sort of thinking is precisely the mistake that got the pension fund industry (and many of their actuaries) into big trouble.

Here is one of the axioms of financial economics. If you are going to assume a higher expected investment return — like 6.5% — compared to what is available with no risk, then you must also allow for the possibility that things will not work out and you might earn much less than expected. Average the two scenarios — and account for this risk properly — and you are left exactly where you started, namely the present value of your $1,000 under a risk-free return is $230,000 if you plan to life expectancy and $385,000 if you plan to the 95th percentile. OK, here it comes: There is no free lunch.

Here is my view. If you don’t like how big this number looks — and you want certainty — then save more, retire later and plan to spend less. Assuming or expecting or anticipating 6.5% or planning to age 90 (only) won’t solve a structural funding problem. Greece is a nice place to retire, but not a very good role model for how to manage retirement finances.

Now let me get to my second of two points, which is the cost of a real inflation-adjusted life annuity, displayed in the final row of the table.

Here is a fact. If you spend $230,000 on a life annuity from an insurance company, it will generate the desired $1,000 per month income — adjusted by the consumer price index — with no investment or mortality risk. You don’t have to assume how long you will live or assume what your portfolio will earn over the random horizon of retirement.

As such, the annuity price is effectively the cost of your retirement income plans and the only answer to the question posed in the title of this column. Any other answer involves extra risk, possibly invisible to the naked eye. It is often obscured from view thanks to heroic assumptions hardwired into financial calculators.

Alas, when I present the above arguments to practitioners — retirement is expensive and you shouldn’t be entitled to gamble down the cost — the reaction goes something like this. What about income taxes? What about health care expenses? What about planning for a spouse? What about nursing home costs and long-term care? Hey, we are doing our best…

Jeez. What about global warming and the situation in southern Sudan? Obviously the world is very complicated and planning software can help navigate the complexity. That said, these calculators should not allow users to move financial and longevity risk off-balance sheet without immediately displaying the implications of taking this extra risk.

In sum, assuming a more aggressive rate of return — or planning to some arbitrary age — and then claiming that retirement has suddenly become “cheaper” is a dangerous fallacy that will end up costing many retirees quite dearly. Ask anyone who assumed a 6.5% investment return over the last decade — or the 100,000 American centenarians — how their retirement is panning out.

More importantly, a life annuity should not be viewed as just another (expensive) way to finance a retirement income or, worse yet, as just one possible tool in a growing arsenal of products. Rather, the annuity price is actually a market signal of what retirement really costs. And, it is the cheapest and safest way to convert a nest egg into a lifetime of secure income. Market prices convey information and the cost of a life annuity is a hard-drive full of intelligence.

Alas, the real dilemma is what fraction of your nest egg you really want to allocate to actual retirement — and eventually convert into some sort of life annuity — and what fraction should be allocated to the kids, the grandkids and beyond, perhaps using life insurance and other estate transfer tools. That is a personal decision that has less to do with expected returns and probabilities and everything to do with personal preferences. Extracting this information from clients in a consistent manner is precisely where advisors can really add value.

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